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London - Spain's plan to rid banks of toxic real estate
assets is reviving the politically heated debate over how creditors and
taxpayers should share the vast losses still being incurred by the eurozone
debt crisis.

Nowhere is the issue in sharper relief than in Ireland.

The government took an €85bn International Monetary Fund
(IMF)/European Union rescue package to bail out the country's banks, felled by
a reckless decade-long building boom, and extended a blanket guarantee to
€440bn of the banks' liabilities, including senior bonds.

As a result, Ireland's total debt soared from 44% of gross
domestic product (GDP) in 2008 to 106% last year, according to the IMF.

The overriding reason why Dublin cannot bow to public calls
to "burn the bond holders", even if it wanted to, is simple: the
European Central Bank (ECB) would not permit it.

The ECB worries that imposing losses on senior bond holders
in one country would instantly spread contagion throughout the 17-member
eurozone.

So Iceland, not in the eurozone, could snub the creditors of
its failed banks; Ireland could not.

This experience colours the advice that Irish academics
proffer to Spain, which is hoping to cleanse banks of their sour property loans
without adding to a public debt burden that is already so high that some
investors believe Madrid too will need aid from the IMF and EU.

"Resolve the banks if you have to and don't get forced
by the ECB into paying 100 cents on the dollar to bond holders in banks that
are bust, which is what we were forced to do," said University College
Dublin economics professor Colm McCarthy.

The ECB's fear that forcing losses on bond holders would
rattle markets was borne out to a large extent during last year's negotiations
over a second IMF/EU rescue for Greece.

After months of saying no, the ECB relented in July and accepted
the need for holders of Greek sovereign bonds to take a 21% writedown. Soon
after, the government bonds of Italy and Spain came under heavy pressure.

"The ECB would say the same would happen to the senior
bond market. You'd kill it for a long, long time and they're anxious to avoid
that," said Alan Ahearne, a professor of economics at the National
University of Ireland in Galway.

Shareholders and owners of subordinated debt have shared in
losses during the crisis and in some cases have been wiped out.

"But it's still the case that no senior bank bond
holder has taken a loss in the euro area, and I see no signs of flexibility
from the ECB on that,"” Ahearne said.

The state's broad shoulders

Ahearne learned the hard way what happens when a banking
system is drowning in bad debt.

He was special adviser to late finance minister Brian
Lenihan when Ireland set up a "bad bank", the National Asset Management
Agency (NAMA), in December 2009 to buy tens of billions of euros of property
loans that were under water and sinking fast.

Without a change of heart by the ECB, Ahearne said any
losses in excess of Spanish banks' equity and subordinated debt would
ultimately be borne by the state.

"If property prices keep falling - and they're likely
to keep falling in an environment in which the economy is continuing to
contract - those losses will be mounting.

"And unless something changes in the European approach,
those losses will fall on the Spanish taxpayer," he said.

Officials in Madrid insist that Spanish banks' €184bn of
troubled real estate assets are manageable, not least because new provisioning
rules will force the lenders to write down some 60% of that total.

Nevertheless, the government wants banks to start
transferring dud real estate assets soon, on a voluntary basis, to liquidation
companies.

Spain has restructured its banking sector three times and is
confident that a carve-up will obviate the need for another rescue of the
banks, whose non-performing loan ratio has risen to 8.2%, an 18-year high.

Investors are less confident. Suspecting that the state will
have to write a cheque at the end of the day, they have driven up yields on Spanish
bonds that are unsustainably high in the long run. Ten-year yields eased on
Friday to around 5.70 percent.

"Spain is trying to find a way to have its cake and eat
it too. They want to get these assets of the balance sheets of the banks. On
the other hand they don't want the central government to take on liabilities
that would balloon out Spain’s debt to GDP.

"So they have to find a compromise,” said Marchel
Alexandrovich, European financial economist at Jefferies, an investment bank,
in London.

Catch a falling knife

Much depends on how far real estate prices still have to
fall. So far, house prices in Spain are down 22% from their 2007 peak, compared
with slumps of 34% in the United States and 49% in Ireland.

"Unfortunately, the Spanish government has not clearly
explained how much more adjustment they expect for the Spanish housing market,
what this implies for the banking sector, and how the government intends to
deal with the consequences," Deutsche Bank economists Thomas Mayer and
Jochen Moebert wrote.

Although Spanish property experts point to an array of
factors that make it unlikely that prices will fall by more than another 15%,
the IMF has said "greater reliance on public funding may be needed",
while Moody's Investors Service sees a risk that the banks could still become a
burden for the state.

In a note published on Friday, economists at Barclays
Capital estimated future expected losses for the Spanish banking system of
€198bn.

Banks had made €110bn of provisions as of the end of 2011,
leaving €88bn of losses to be cover, BarCap calculated.

Profits over the next two years and buying back discounted
junior debt might yield €40bn, but the investment bank saw a need for extra
public sector support of €46bn to meet the shortfall in bank capital. The state
has already injected €16bn of capital, it said.

In the absence of external investors, creating an asset
management company, or bad bank, to buy the toxic loans would not reduce the
fiscal cost for Spain of recapitalising the banks. But it could improve
investor confidence if the tainted assets were sold for credible prices.

“This could pave the way for a return of private foreign
capital into the country. However, the process may reinforce investor concerns
if the valuation process shows large provisioning shortfalls,” BarCap
concluded.

Balancing act

Trinity College Dublin economics professor Philip Lane said
the trick was to purge the banks of sufficient risk so their books are
"clean" once more in the eyes of the markets, without saddling the
government with too big a bill.

"To guard against being overly generous from the
taxpayer's point of view, some of the downside risk would stay at the bank. If
the transfer values are too good, down the line it would be recouped from the
banks," Lane said.

Ireland's experience shows just how difficult it can be to
set the right price in fast-falling markets.

Even after Nama took a huge chunk of bad loans off Irish
banks starting in February 2010, house prices continued to fall and mortgage
arrears kept rising, exposing an additional capital shortfall last year of
€24bn.

The total cost of recapitalisng Ireland's banks so far is
estimated at €86bn, or 52% of GDP.

For McCarthy, the University College Dublin economist,
making governments pay for disastrous private sector lending decisions is not
just iniquitous. By refusing to countenance losses for senior bond holders, the
ECB is destroying market discipline, he argued.

"We have built a moral hazard machine and it needs to
be stopped," McCarthy said.

"There is no market discipline if you continue to give
100 cents on the dollar to people who bought bonds in banks that are closed in
the Irish case."

Having governments assume banks' obligations to their
creditors also risks doing permanent damage to the sovereign bond market
because buyers will stay on strike if they cannot quantify states' contingent
liabilities, he said.

"Clearly, the ECB thinks that bank debt is more
important that sovereign debt. But there comes a point where these things just
have to be faced.

"A sovereign insolvency in Spain, or in Italy for that
matter, runs the risk of a very big financial catastrophe in Europe,"
McCarthy said.

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